Indiana: Commissioner’s Directive construes tax exemptions related to the Final Four

The Indiana Department of Revenue (INDOR) published a Commissioner’s Directive (Directive) late last year to provide guidance to the National Collegiate Athletic Association (NCAA) and retail merchants on tax exemptions during the Final Four event that takes place in Indiana, including all ancillary associated events.

Under Indiana state law, the following are exempt from taxation for all purposes: Revenues, expenditures, and transactions resulting from holding the actual event or from making preparatory advance visits to Indiana. And all property owned by the National Collegiate Athletic Association (NCAA) and its affiliates in connection with a Final Four event in Indiana.

Here are the categories of tax exemptions:

1. Sales and use taxes: Purchases of tangible personal property or taxable services by the NCAA or an affiliate in connection with a Final Four event are exempt from sales and use taxes, as long as the purchase was made directly by the NCAA or an affiliate.

The Directive explains that there is no exemption if the purchaser is an NCAA employee unless the purchaser has a master account with the retail merchant. The purchaser must:

Provide a list of employees authorized to make charges to the master account;

Provide the master account information to the INDOR; and

Submit an exemption certificate to the retail merchant.

Refunds are available by filing a properly supported claim with the INDOR.

In addition, sales by the NCAA and affiliates are exempt from sales and use taxes. To the extent that it has gross receipts that would otherwise be subject to tax, the NCAA or affiliate must timely file monthly sales tax returns with the INDOR for any month in which it has tax-exempt sales.

2. Excise taxes: Purchases and sales made by the NCAA and affiliates are exempt from state and county excise taxes. This includes gasoline or motor fuel tax, special fuel tax, auto rental and county auto rental excise tax, county food and beverage tax, innkeeper’s tax, and county admission tax. Refunds are available by filing a properly supported claim with the INDOR.

3. Income taxes: To claim this exemption, the NCAA or affiliate must comply with the following:

Submit a report by the appropriate filing date detailing the exempt income; and

Include this report as an enclosure with the income tax return, if required to file one.

4. Withholding taxes: The NCAA and affiliates are exempt from the withholding tax on the wages and salaries of employees unless the employees are residents of Indiana.

The Directive offers several examples to illustrate how these exemptions work in practice.

States react to the effects of their income tax policies

The Kansas experiment

In 2012, Gov. Sam Brownback instituted what was widely regarded as the most ambitious tax cut of any state. At that time, the Tax Foundation opined that his idea, which included the elimination of the income tax for pass through entities, would encourage inefficiency because it rewarded certain business structures over others without any economic justification. The Tax Foundation continued that “[u]ltimately, large and small businesses are both important to the economy and states should resist favoring one at the expense of the other.”

Despite criticism, voters appeared happy with the tax cuts and re-elected Gov. Brownback in the 2014 midterms by a narrow 3.9 percent margin.

Even with the governor’s re-election, the Kansas experiment, nicknamed Brownbackonomics, is not a panacea. CNNMoney described a “predicament” in which the legislature is now tasked with finding hundreds of millions of dollars to balance the state budget that faces a $280 million shortfall this fiscal year. In addition, the anticipated boost for the economy in general and small businesses in particular, has not materialized, and it may take years to realize the benefits of the tax cuts.

A tax policy expert from the Tax Foundation attributed the unexpected budget shortfall to the income tax exemption extended to small business and partnership profits, effects of which were exacerbated by non-exempt firms restructuring to become eligible for the zero percent tax rate.

In addition, CNNMoney quoted a law professor at Washburn University in Topeka, who pointed to the untargeted nature of the cuts, recognizing that the zero percent income tax helped more than just small businesses, like partnerships and S corporations, “which are not really small businesses at all.” She further hypothesized that not predicating the tax exemption to some benefit, such as job creation, resulted in the situation that Kansas now faces.

Possible solutions

Shawn Sullivan, Kansas’ Budget Director, offered proposals for achieving reductions in spending, which include the following:

Transferring $201 million of funds from the State Highway Fund and the Department of Health & Environment, among others;

Reducing the state’s contribution to the Kansas Public Employees Retirement System (KPERS) by $40 million; and

Enacting a four percent reduction to the Department of Education and other agencies.

CNNMoney asserted that even these steps may not solve the problem. KPERS is already underfunded, fund transfers can only be used once, and a district court recently ruled that the K-12 education system is underfunded.

2015 budget proposal

Despite all of this, Gov. Brownback recently announced his new tax proposal that provides further relief to taxpayers in the Sunflower State. Trumpeting the fact that prior tax rate reductions have “put $730 million back into Kansas taxpayer’s pockets in just the first year,” the proposal calls for a transition to consumption taxes. For example, the proposal includes:

The cigarette tax would increase from 79 cents to $2.29 per pack, the first increase in 12 years;

Tobacco product prices, for the first time in 43 years, would increase from 10 to 25 percent of the wholesale price; and

The liquor enforcement tax, which has not changed in 32 years, would increase from 8 to 12 percent.

The proposal also includes a tax amnesty program, expected to generate $30 million, and income tax cuts, some of which would be tied directly to state tax receipt growth. According to the proposal, the lowest tax bracket would drop to 2.66 percent on Jan. 1, 2016, resulting in an $11.7 million tax reduction. These, and further cuts, would not become effective until tax revenues exceed 103 percent of the previous fiscal year’s receipts.

Ohio’s Governor Kasich takes a similar approach

Gov. John Kasich’s budget proposal released at the beginning of February also proposes significant income tax cuts. As we wrote when it was released, the proposal reduces overall state taxes by $500 million, in part by shifting tax burdens from income to consumption based taxes, including a $1 increase in the cigarette tax. The proposal also offers complete elimination of the income tax for pass-through entities. Ninety-eight percent of small businesses, or almost one million firms, are classified as pass-through entities in Ohio. However, The Plain Dealer reported that small businesses are actually expected to realize a tax savings of less than $364 per year under the provision.

The Tax Foundation, as with the Kansas plan, characterized Gov. Kasich’s tax cut as poor tax policy because, despite the reductions, it does not address some of the biggest problems facing Ohio. These include the most onerous municipal income tax system in the country and a state corporate tax that is a highly criticized gross receipts tax, which results in a dismal No. 44 ranking in the Tax Foundation’s State Business Tax Climate Index.

Beyond this, the Tax Foundation described Ohio’s exemption for pass through entities as “a tax gimmick du jour made famous (not in a good way) by the ill-fated tax experiment in Kansas. The idea for excluding small businesses from tax liability is to promote job creation and growth in the state, but the unintended consequence of this policy is that it allows wage earners to change their structure to avoid paying any income taxes.”

Asserting its concern for Gov. Kasich’s “track record of proposing handfuls of hikes to other damaging taxes to make the budget numbers add up,” the Tax Foundation depicted good tax reform as being “composed of broadening the base, and lowering the rate. The Kasich plan would be a significant narrowing of the tax base, and that makes revenues less stable and less fair. If the governor wants to give Ohioans an income tax cut, why not just do it across the board?”

In contrast, Connecticut eliminates some corporate tax exemptions

Connecticut Gov. Dannel P. Malloy recently announced his budget proposal for fiscal year 2016-17. An “ambitious agenda” designed to “transform Connecticut’s infrastructure [and] overhaul the sales tax to bring it to the lowest level since 1971,” the $40 billion budget reduces sales tax from the current rate of 6.35 percent to 6.25 percent on Nov. 1, 2015, and to 5.95 percent on April 1, 2017.

In addition, the announcement highlights a total spending increase of just 3.1 percent, which is under the spending cap, the elimination of the $250 biennial business entity tax for all corporations, including sole proprietorships, and a transformation plan for the state’s transportation system, among other things.

The Tax Foundation explains that the proposal broadens the sales tax base by eliminating existing exemptions on groceries, medical supplies, vehicles, textbooks, bicycle helmets, and clothing. These exemptions totaled $3.7 billion in 2013. If the sales tax had been levied across these categories, a 3.34 percent rate would have generated the same revenue as the 6.35 percent rate did. Combined with the reduced rate, the scheme “will ultimately become a roughly revenue-neutral adjustment, albeit with a first-year windfall of $70 million.”

Despite the elimination of the biennial business entity tax, the Tax Foundation points out that the removal of various corporate tax exemptions is not offset by reduced rates to achieve revenue neutrality. Gov. Malloy’s proposal includes an “astonishing 43.6 percent increase in business taxes in [fiscal year] 2016, to decline somewhat thereafter, while still remaining well above the current baseline.” To accomplish this, the proposal includes the following:

Eliminating the sunset of a 20 percent corporation tax surcharge, which keeps Connecticut’s corporate rate at nine percent rather than allowing it to return to 7.5 percent;

Capping the use of net operating losses to 50 percent of liability, which penalizes companies that experience greater volatility across the business cycle; and

Capping the use of tax credits to 35 percent of tax liability for calendar year 2015, 45 percent in 2016, and 60 percent in 2017 and thereafter.

The Tax Foundation notes that certain corporate exemptions, like film tax credits, job creation tax credits, research and development credits, and industrial site reinvestment credits, unnecessarily erode the base, and that a lower rate would do more to promote economic growth. Instead, the budget keeps the corporate rate of nine percent too high, and ultimately results in that 43.6 percent increase.

Conceding that eliminating tax credits and exemptions can be good policy, the Tax Foundation ultimately concludes that Connecticut’s “anomalously high business taxes” are just too high, risking “substantial harm to the state’s prospects for employment and economic growth.”

Alabama’s governor also proposes corporate tax increases

This week, Gov. Robert Brantley announced his ideas for filling Alabama’s $700 million funding shortfall. While the state has recently attempted to utilize one-time revenue sources to support its activities, debt continues to mount. This is so, in part, because the one-time only taxes do not result in sustainable revenue streams year in and year out, which would help Alabama keep up with inflationary costs.

Corporate income tax: Require combined reporting for a $20 million increase in revenue;

Individual income tax: Eliminate the income tax withholding exemption certifications for a $12 million increase in revenue;

Financial institution excise tax: Remove the credit for sales taxes paid for a $1 million increase in revenue;

Cigarette and tobacco tax: Increase the tax from $0.825 per pack to $1.25 per pack, increase the tax on other tobacco products proportionately, and maintain the existing wholesaler’s discount for a $205 million increase in revenue;

Automobile sales and rental taxes: Increase both rates to four percent for a $200 million and $31 increase in revenue, respectively;

Public utilities license tax: Remove the exemption for municipal utilities for a $47 million increase in revenue; and

Insurance premium tax: Remove credits for state privilege tax paid, ad valorem tax paid, and remove the office facilities and real property investment credits for a total $25 million increase in revenue.

AL.com reported that these measures will result in $541 million in new revenue.

Americans for Tax Reform decried the effort as a violation of Gov. Brantley’s campaign promise to “oppose any and all tax increases.” Gov. Brantley’s announcement reminds Alabamans that he has “spent the last four years making [the] government operate more efficiently and effectively, saving taxpayers over $1.2 billion annually.”

Implications

The concept of a three-legged stool of good tax policy—income, sales, and property tax—is a simple idea. But, as these governors are experiencing, the solutions are complex and not easy to implement. The implications of excessive corporate taxes, hindering job and economic growth, are as obvious as those of too little taxes, like a crumbling infrastructure and underfunded services that are critical to a healthy economy.

Hybrid-origin sourcing: Is a change in the method of collecting sales tax on the horizon?

As we reported, states are increasingly focused on uncollected sales and use taxes as a means to increase tax collection revenue, especially the collection of sales taxes related to e-commerce transactions. The Tax Foundation estimates that Americans spent about $263 billion on Internet retail purchases in 2013, which represented a 15 percent increase over the previous year. The growth of Internet commerce is expected to continue, and Internet retail sales are expected to represent a larger share of the $4.5 trillion spent annually on retail consumption.

While the imposition of sales and use taxes has been a common feature of state and local tax regimes for a long time, the manner in which retail transactions are conducted has evolved significantly. General state sales taxes first became prevalent during the Great Depression because of the collapse of revenues from property taxes. By 1940, 22 states and Hawaii had adopted a sales tax. Today, 45 states and the District of Columbia impose a statewide sales tax. In addition, there are 9,998 sales tax jurisdictions nationwide that impose a form of local sales tax. In total, taxpayers paid $259 billion in state sales tax and $70 billion in local sales tax during 2013.

In every state imposing a sales tax except three, the sales tax is structured as a tax on the consumer’s purchase of tangible personal property not exempted; meaning the sales tax is charged on most goods but few services. Further, of those states, almost all impose the sales tax based upon a destination sourcing sales tax regime. This means that the location of the sale is considered the location where the consumer receives the good. Destination sourcing is based upon the idea that the sales tax is borne by the consumer purchasing the item and therefore should be based upon where the consumer resides.

The Chairman of the House Judiciary Committee, Robert Goodlatte, recently circulated draft legislation addressing the collection of tax on remote sales. The terms of the draft legislation, Online Sales Simplification Act of 2015 (the Draft Act), differ from previous iterations of the sales tax legislation, such as the Marketplace Fairness Act of 2013, which adhered to destination sourcing of sales. The Draft Act proposes utilizing hybrid-origin sourcing (Hybrid) as the basis for collection of sales and use taxes. Under the Hybrid model the sale would always be sourced as the taxing jurisdiction of the seller. Adoption of a Hybrid approach would significantly transform the structure and collection of sales and use taxes in the United States.

The Draft Act provides that a state may require collection of sales tax on a remote sale (e.g., an Internet sale by a seller without a physical presence in the destination state) only if: the state is the state of origin for the remote sale and the state is a party to a distribution agreement, which will be developed by participating states. The distribution agreement among the participating states would establish a clearing house by which the sales tax revenues are shared among the participants. If a state does not become a party to the distribution agreement, it is not allowed to levy a tax on a remote sale and will not receive a distribution. In addition, subject to certain exceptions, the destination state would not be allowed to impose any additional tax if the remote seller collects the tax pursuant to the terms of the Draft Act.

A remote seller based in a participating state would collect the tax on its sales at the rate and according to the rules in seller’s location, the “Origin State.” The tax collected by the remote sellers would be remitted to the Origin State, which would then send the taxes collected and information about the remote sale to the clearinghouse. In turn, the clearing house would distribute the funds to the destination state. It is unclear what would happen to sales taxes collected on sales into states not participating in the distribution agreement.

Some additional concerns with the Draft Act will need to be addressed and clarified prior to voting to adopt the Hybrid method, and transforming the structure and collection of sales and use tax. For instance, a method to collect a sales tax for sales originating from the five states which do not impose sales tax (i.e., Alaska, Delaware, Montana, New Hampshire, and Oregon) will need to be developed. That method will also need to determine which items qualify for a sales tax exemption as these rules vary by taxing jurisdiction.

Opponents of the Draft Act also assert that a Hybrid model problematically transforms the sales tax into a business tax because compliance will be legally and economically shifted to businesses. Imposition of taxes under the Hybrid method would impose a tax based upon production but distribute based upon consumption, which may result in distortions in state tax revenues and present opportunities of tax arbitrage.

Further, the Draft Act will need to pass Constitutional muster and comply with both the Commerce Clause and the Due Process Clause. In its present form, there appears to be the potential that customers in the same state could be taxed at different rates based upon the seller’s Origin State. Also of concern is that customers in states with no sales tax may, in effect, pay a sales tax if their purchases are from remote sellers in states with a sales tax. Finally, clarification will be needed as to whether a state that imposes a higher rate of tax than an origin state should be precluded from collection a use tax on the differential.

McDonald Hopkins will continue to follow developments and changes as the Draft Act and comments from industry groups makes its way through the legislative process. To discuss how this proposed legislation may impact your business, please contact us:

Businesses must be vigilant and careful in managing their state and local tax liabilities and exposures. We understand this can be a daunting task. McDonald Hopkins Multistate Tax Services provides a broad range of state and local tax services including tax controversy, tax evaluation, tax planning, and tax policy. With professionals who have worked both inside and outside government agencies, our multistate tax team leverages its knowledge and experience to help clients control their complex multistate taxes.